Is There Any Hope for Emerging Markets?

Emerging US Stocks

Emerging market stocks have been among with worst-performing asset classes this year. While so far in 2015 US stocks are down slightly and international developed stocks are slightly up, emerging market stocks have lost more than 12%. And this isn’t a new phenomenon: in 3 of the previous 5 calendar years emerging market stocks have dramatically underperformed their US counterparts. Is there any hope for this battered asset class?

Part of the problem for emerging markets has been declining economic growth prospects. The International Monetary Fund recently lowered its growth estimates for Latin America and Southeast Asia, and it projects that China’s economic growth rate will continue declining. With emerging economies stagnating while growth rates in developed economies are projected to increase, emerging markets seem like a less compelling investment opportunity.

Another part of emerging markets’ problem has been the US dollar, which has soared in value since the middle of last year. A stronger US dollar directly hurts the value of US investors’ emerging market holdings, which are worth less when converted back into dollars. But it can hurt emerging markets in other ways as well. A strong dollar tends to be associated with lower commodity prices, which hurt the many emerging economies that export commodities. And many emerging markets have debts denominated in US dollars, which are harder to repay when the dollar increases in value.

Given these problems, emerging market stocks may seem like a lost cause. But the flip side of poor performance for an asset class is lower valuations, which can improve the prospects for the asset class going forward. The valuations on emerging market stocks overall are below their historical averages and far below the valuations on US stocks and international developed stocks.

Valuations don’t provide much information about what will happen in the short-term, so it’s certainly possible the emerging markets could continue to underperform for a while. Though below their historical average, emerging market valuations are also still above the nadir they reached in 2008, suggesting that another extreme event (such as China’s recent turmoil turning into a full-blown financial crisis) could lead to further declines. But if they’re able to avoid economic upheaval, emerging markets seem well-positioned to finally end their losing streak.

Finding Value in the Selloff Rubble

Rubble

The recent erosion in equities turned into an all-out landslide Monday morning. Globally and in the United States, stocks are now in correction mode, with equities in emerging markets and Europe in a bear market.

The selling has extended into other asset classes, notably commodities and high yield, and has been accompanied by an abrupt spike in market volatility. According to Bloomberg data, the VIX Index, a proxy for U.S. equity market implied volatility, traded over 50 on Monday morning, the highest level since the financial crisis.

However, as I write in my new weekly commentary, “As Markets Plunge, Some Value Surfaces,” and in my new paper, “After the Rout,” I don’t think the selloff is a prelude to another 2008-style cataclysm. Indeed, here’s the key takeaway for long-term investors: The selling has restored some value to most areas of the market.

There was no single catalyst for the brutal selloff. Rather, it appears to have been a delayed reaction to several developments. Further weakness in Chinese data added to concerns over the health of the global economy. Falling inflation expectations and the lingering potential for a monetary tightening by the Federal Reserve (Fed) also contributed to the anxiety. Meanwhile, it could be argued that the spike in volatility is a somewhat overdue response to slower economic growth and deteriorating credit market conditions.

That said, while I believe global growth will remain below trend, the evidence suggests that the global economy is not on the cusp of another recession. Global economic measures, while admittedly suffering from relatively short histories, are suggesting that growth should remain positive. Both the Global PMI and Global Services PMI are comfortably in expansion territory, Bloomberg data shows.

On a regional basis, U.S. leading indicators look solid, if uninspiring, and in Europe, recent manufacturing, sentiment and credit surveys are all suggesting further stabilization in growth. In addition, lower oil prices and lower rates should both help stabilize growth.

Assuming the global economy continues to expand, the recent selling has returned some value to many financial assets. Though stocks pared some losses by midday Monday, valuations for most assets are a long way from the tops typically seen prior to bear markets, according to my analysis using Bloomberg data.

Developed market stocks, as measured by the MSCI World Index, are now trading at roughly 2x book value, about 10% below their 20-year average and roughly 25% below their peak valuation in 2007. One example of a developed market region that has been particularly hard hit, probably excessively, is Europe. European equities, as represented by the S&P Europe 350 Index, are now trading at less than 12x forward earnings and 1.3x book value. The selling may be overdone, considering that investors may be exaggerating Europe’s exposure to China.

Elsewhere, the MSCI Emerging Markets Index, which has been particularly hard hit, is trading at less than 12x earnings and barely 1.25x book, a level last seen during the lows in early 2009.

The selling has even restored some value to U.S. equities. The S&P 500 is now trading for less than 15x forward earnings, and the Dow Industrials is now selling for barely 13x next year’s earnings.

There’s a similar story in credit. Take U.S. high yield, one of the hardest hit segments. The asset class, represented by the Markit iBoxx USD Liquid High Yield Index, has seen spreads relative to Treasuries widen sharply, despite the fact that defaults remain well below historical levels.

The bottom line: While higher volatility is here for the foreseeable future, the selloff has created a number of potential opportunities for investors with longer-term holding periods.

This post, Finding Value in the Selloff Rubble, first appeared on the BlackRock blog.

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to BlackRock’s The Blog and you can find more of his posts here.

 

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

©2015 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

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It’s OK to Take a Loss

Up Down

Investors tend to be much more willing to sell investments that have increased in value than those that have fallen. Psychologists even have a name for this kind of behavior: loss aversion. But being too eager to sell “winners” and too hesitant to sell “losers” can hurt your investment performance.

One problem with loss aversion is that it can distort your portfolio. Since investments with exposures to the same parts of the market often move up and down together, selling winners while holding losers can leave your portfolio overexposed in some areas and underexposed in others. That can reduce your diversification and inadvertently increase the amount of risk you’re taking.

Even if you manage to maintain a diversified portfolio, loss aversion could cause you to get rid of investments that are going to do well going forward and keep the ones that are going to do poorly. Stocks, for example, tend to have a “momentum effect,” meaning that the ones that have recently gone up are more likely to do well in the near future.

Loss aversion can also hurt when it comes to taxes (at least in taxable investment accounts). Since you don’t pay taxes on many investment gains until the investment is sold, being too eager to sell your winners can mean paying more taxes. And since in some cases selling investments at a loss can reduce your tax bill, being too hesitant to sell losers might mean higher taxes as well.

So how can you prevent loss aversion from harming your portfolio? It’s not always easy, but the key is to focus on what you ideally want your portfolio to look like. If a decision to sell an investment would bring you closer to that ideal portfolio, it’s probably worth doing. If it wouldn’t, you may be better off standing pat.

Why High Yield Still Has a Role to Play

Field

A darling asset class of this bull market has been U.S. high yield debt, as many searching for income in a low-rate world have turned to these higher-yielding bonds. According to Bloomberg data, on an annualized basis through July 31, the Barclays U.S. High Yield two percent Issuer Cap Index has gained 14.9 percent since December 2008, trailing only the S&P 500 Index (up 16.1 percent) in performance.

However, with a Federal Reserve (Fed) rate hike on the horizon for later this year and universal acceptance that it’s late in the current credit cycle, some investors are considering abandoning the asset class. The fear is that outflows from high yield could continue, putting it under pressure, and some have even speculated that high yield debt may be the next “Big Short.”

Given all this, high yield may still have a portfolio role to play for investors. Here’s why.

1. THERE’S VALUE THERE.

It’s hard to argue that high yield is cheap. Spreads (yield minus the yield of comparable U.S. Treasuries) are currently 575 basis points (bps), down from 1,930 bps in 2008, according to Bloomberg data.

But while high yield certainly isn’t cheap, the recent widening of spreads has returned some value to the asset class. Today’s high yield spread is still 135 bps above pre-2013 Taper Tantrum levels and 175 bps above the tightest post-crisis levels reached in June 2014, according to Bloomberg data. Looking forward, since the Fed has telegraphed its intent to normalize policy rates, we don’t expect another Taper Tantrum, and current spreads appear to offer fair compensation, at least on a relative basis.

2. AND ATTRACTIVE YIELDS.

Although volatility could persist, yields are attractive relative to other yield-generating instruments. Also, the current incremental pickup in yield relative to volatility looks reasonable as compared to that of fixed income alternatives.

3. FUNDAMENTALS REMAIN ATTRACTIVE.

Defaults in the high yield space still remain low, currently sitting at 1.9 percent, well below the 25-year average of 3.6 percent, according to J.P. Morgan Credit Research as of July 31.

It’s also important to remember that high yield has actually performed quite well in rising rate periods, as the chart below shows. It also tends to perform well in a positive growth environment, holding a 0.76 correlation with U.S. PMI, according to our analysis using data from Bloomberg. While we don’t expect a massive acceleration in growth, we also don’t foresee a recession. The environment we expect—slow, but positive growth—should actually be a favorable one for the asset class, maybe even relative to equities.

High Yield

To be sure, the asset class is not without its risks. Energy and mining sectors represent 20 percent of the Barclays Capital High Yield Index, according to Bloomberg data as of July 31. Yet surprisingly, oil prices can explain 70 percent of the movement in spread levels of the entire index over the last year, our analysis shows.

High yield debt issuance has also continued to reach record levels, though we expect there will not be a rush to issue once the Fed moves on rates. In addition, high yield shares certain characteristics with stocks, so investors who are already heavily exposed to equities should consider a more modest allocation. In other words, allocation to high yield needs to be viewed in the context of an entire portfolio. Finally, as we see higher levels of stock market volatility, high yield volatility is likely to rise as well.

But here’s the bottom line: While there’s no denying the above risks, high yield’s positives still argue for some allocation in portfolios, particularly for investors with aggressive income objectives.

 

This post, Why High Yield Still Has a Role to Play, first appeared on the BlackRock blog.

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to BlackRock’s The Blog and you can find more of his posts here.

 

Investing involves risk, including possible loss of principal. Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

©2015 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

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How China Affects American Markets

China Exchange Rate

China’s financial markets have been making headlines recently, and generally not in flattering ways. First its bubbly stock market soared and subsequently crashed. Then concerns spread about the country’s slowing economic growth. This week the country’s central bank reduced the value of its currency, the yuan. How much will these events affect financial markets in the US?

At first glance the effects on the US should be mild. Though China is the world’s second-largest economy, its financial markets are not a commensurate size. It makes up less than 3% of the MSCI ACWI, an index representing the global stock market. Only about 2% of large US companies’ revenue comes from China. And as of last year less than 1% of global currency transactions involved yuan.

The most recent upheaval—the decline in the value of the yuan—wasn’t even particularly large. The currency fell by a few percentage points against the US dollar over the course of two days. While such a move is unusual for the yuan (which the Chinese government keeps loosely pegged to the dollar) it pales in comparison to other currency movements. Russia’s ruble, for example, fell by more than 30% against the dollar in a single month at the end of 2014. And the US Dollar Index, which measures the value of the dollar against a handful of other currencies, has risen during the past year, meaning that the yuan is still far worth more compared to most currencies than it was 12 months ago.

China’s financial market turmoil could still end up having a sizable adverse effect on the US, but only to the extent that it may signal more bad news to come. The decision to let the value of the currency decline, for example, could indicate that the economy is doing worse than publicly-released data suggests. It’s also possible that the currency devaluation was just the first step in longer-term effort to try to boost the Chinese economy by weakening the yuan. Such a shift could cause both economic and political trouble in the US.

What Google’s Restructuring Will Mean

Google Search

On Monday Google announced that it is reorganizing its business and will create a new company called “Alphabet.” The internet businesses that generate most of the current company’s revenue (such as its ubiquitous search engine and YouTube) will be put into a subsidiary called “Google” that will be owned by Alphabet. The current company’s other endeavors (such as its attempts to build self-driving cars and Nest, its internet-connected household products business) will also be subsidiaries owned by Alphabet but will be separate from the subsidiary called Google.

The key to understanding why Google would shuffle its corporate structure is the company’s ownership. Even as it has become one of the world’s largest companies (its market value is currently more than $450 billion), Google’s founders have ensured that they retained control of the company and couldn’t get outvoted by other shareholders. That control has given them more flexibility to invest in longer-term ideas such as the self-driving cars without worrying that disgruntled shareholders would replace them with new executives.

By splitting the core internet business from these longer-term projects, the new company will be providing more information to investors about the financial performance of the core business and how much money is being invested in everything else. By trying to separate investors’ perceptions of how the internet business is performing from how much money is being invested in the longer-term projects, it could also (much like the company’s convoluted ownership structure) give Alphabet’s executives more flexibility to invest in the longer-term projects.

Whether this is good news or bad news for Google’s shareholders depends on how much confidence they have in the company’s executives. For those who believe that Google’s ownership structure gives its executives the freedom to make necessary long-term investments that will eventually pay off handsomely, the change should be cheered. Those who believe that Google’s ownership structure is a license to waste shareholders’ money on executives’ pet projects should have a less favorable assessment.

How Long Will the Energy Sector’s Struggles Last?

Energy Sector Performance

One of the largest upheavals in financial markets during the past year has been the plunge in the price of oil. The price of West Texas Intermediate crude oil (one of the main gauges of “the oil price”) has fallen from over $100 per barrel in July 2014 to around $45 per barrel. This decline has decimated the energy sector, which has lost almost 30% of its value over the past year while the overall US stock market has gained more than 10%. Is the energy sector’s underperformance a short-term aberration or part of a longer-term trend?

Part of that answer depends on the outlook for the oil price. After rallying a bit this spring, the oil price resumed its descent in July. The prospect of increased Iranian oil production following the country’s nuclear deal with the US and other countries, high levels of global oil production, and worries about a potential slowdown in China’s economy all likely contributed to the fall. Each of these factors could persist for a while, so the oil price may not bounce back any time soon.

Another part of that answer depends on whether energy companies can adapt to lower oil prices by reducing their costs, for example by decreasing the size of their workforces and investing less in new exploration. By some estimates there have been almost 200,000 layoffs in the global oil industry since the middle of last year. The lower supply resulting from these changes could help the oil price arrest its decline and at least partially restore energy companies’ profits.

But low oil prices probably don’t explain all of the losses for energy stocks. In fact, the sector’s 40% underperformance compared to the broader stock market during the past year is far more extreme than during other recent oil price declines, even the 70% collapse in the oil price during the second half of 2008. It’s therefore likely that longer-term factors have contributed to the sector’s recent struggles as well.

Two such factors that have accelerated recently are the rise of alternative sources of energy and more stringent environmental regulations. These may be more difficult for energy companies to adapt to than a changing oil price, and they could continue to be a drag on energy stocks even when the oil price rebounds.